How to Think About Time Value of Money Problems

One of the biggest obstacles to correctly solving time value of money

problems is identifying the cash flows and their timing. On this page I will offer
some tips that I hope will be helpful.

There are Always Five Variables

Every time value of money problem has five variables: Present value (PV),
future value (FV), number of periods (N), interest rate (i), and a payment
amount (PMT). In many cases, one of these variables will be equal to zero, so
the problem will effectively have only four variables. You will always know the
values of all but one of these, and it is that missing value for which you will be
solving. 

It may seem that problems involving uneven cash flow streams don't fit the
description above, but they do. Thanks to the principle of value additivity, we
can think of uneven cash flow streams as a series of lump sum cash flows. If
necessary, you can always deal with each cash flow separately, and then add
up your results in the end.

Identify The Variables

The most important thing is to be able to identify the variables that you have
been given, and the one that you are looking for. What makes this difficult,
sometimes, is that you are given a problem (sometimes a long one) and you
have to identify the variables amidst a bunch of words. Furthermore, the
words that are used and the order in which the variables are given is never
the same. That leads us to the first tip:

Tip: When reading through a time value of money problem you should
always stop when you come to a number. Write down (and label)
that number to the side of the problem. That way, you will have
separated the values from the text.
As noted above, there are up to five variables in every problem. Here are
some general ideas about how to identify them:

Present Value
Any value that occurs at the beginning of the problem (or the beginning of a part
of the problem) is a present value. The key is that the present value occurs
before any other cash flows. Usually, when a present value is given, it will be
surrounded by words indicating that an investment happens today.

Future Value
The future value is usually the last cash flow. Obviously, it is a cash flow that
occurs at some time period in the future. The future value is a single cash flow. If
it occurs more than once, then it is probably an annuity payment.

Annuity Payment
An annuity payment is a series of two or more equal payments that occur at
regular time periods. Each payment, if taken alone, is a future value, but the key
point is that the annuity payment is a recurring payment. That is, there are more
than one of them in a row.

Interest Rate
The interest rate is the growth rate of your money over the life of the investment.
It is usually the only percentage value that is given. However, some problems will
have different interest rates for different time frames. For example, problems
involving retirement planning will often give pre-retirement and post-retirement
interest rates. Frequently, when you are being asked to solve for the interest rate,
you will be asked to find the compound average annual growth rate (CAGR).

Number of Periods
The number of periods is the total length of time that the investment will be held.
Typically, it is given as a number of years, though it will often need to be adjusted
to some other time scale. For example, if you are told that the investment pays
interest quarterly (4 times per year) then you must adjust N so that it reflects the
total number of quarterly (not annual) time periods.

Tip: The interest rate, number of periods, and annuity payment

variables must all agree on the length of a time period (a
day, a week, a month, a year, etc). That is, i is always the
interest rate per period, N is always the total number of
periods, and PMT is always the amount of the payment per
period. Very often, it is necessary to make adjustments to
the values given in a problem. For example, interest rates
are usually given as annual rates. However, if payments
occur monthly, then the interest rate must be adjusted to a
monthly rate (typically by dividing the annual rate by 12).
Similarly, the number of years would have to be changed to
the number of months.
Draw a Time Line
Even after you have successfully identified the cash flows, it can be difficult to
track the timing of the cash flows in your head. This is where time lines are so
important. A time line is a graphical representation of the size and timing of
the cash flows.

When you are first learning to solve time value problems, drawing time lines is
a very good idea. In the picture above, you can easily see that the problem
consists of a five-year $100 annuity (PMT), and a $1,000 cash flow (FV) that
occurs at the end of the investment. The time line helps you to see exactly
when each cash flow occurs, and therefore how many periods it needs to be
moved (either forward or backwards in time). As the problems that you are
solving become more complex, the importance of drawing time lines
increases.

Break the Problem into Smaller Pieces

Very often time value problems are pretty straightforward. It may involve only
a single lump sum cash flow, or a simple annuity. For more complicated
problems, it can be very helpful to break the problem into several pieces and
solve them separately. In the end, just add up the answers from each piece of
the problem (this is known as the Principle of Value Additivity). Keep in mind
that we almost always want to know the answer as of some point in time, so
all of the cash flows need to be moved to that time period before they can be
added together.

The time line shown above is a good example of a problem that can be solved
in two (or six, if you want) pieces. To find the present value of that stream of
cash flows, we would find the present value of the five-year $100 annuity first.
Then, find the present value of the $1,000 lump sum. The final step would be
to add the two present values to get the present value of the entire stream of
cash flows.
Sometimes you have no choice but to break the problem into pieces. For
example, when solving problems relating to future retirement income needs.
Very often this type of problem involves two time periods (before retirement
and after retirement), and perhaps also more than one interest rate (usually
lower during retirement). In this situation, you need to treat it as two problems.
First solve the "after retirement" problem, and then solve the "before
retirement" problem using the results from the first part.

Try to Estimate the Answer

One final important tip is to always try to estimate what your final answer
should be. Your estimate doesn't have to be precise. You just want to be able
to identify obviously incorrect answers. This is especially true when using
financial calculators or spreadsheets. Always remember the old saying,
"garbage in, garbage out." If you enter incorrect numbers, or you get the
timing of the cash flows wrong, you will always get the wrong answer.

There are relationships between the variables that you should understand,
and that can help you when estimating the answers. Here is an analogy that
may help:

Think of the problem as a road trip. The present value is your starting point,
and the future value is your destination. The number of periods is the distance
to be traveled, and the interest rate is the average speed that you will be
traveling.

Using that analogy, however imperfect it may be, we can identify several
important relationships between the variables:

 The future value is always bigger than the present value.

 From any given present value (starting point), the longer you drive (N) or the
faster you go (i), the bigger the future value will be.

 If you slow down (use a lower interest rate), it will take longer (larger N) to get
from the present value to the future value. If you speed up (higher interest
rate), you will get there faster (lower N).

 If you drive for less time (lower N), you will have to go faster (higher i) to reach
the same destination (FV).

And so on. There are endless variations, and annuity payments add to them.
The point is that you need to understand how the variables interrelate if you
want to be able to estimate answers. Ultimately, the best way to get good at
solving problems is to solve a lot of them, so practice is very important.